Adverse Selection, Liquidity And Market Breakdown

This paper develops a model that illustrates how even a small amount of adverse selection in the asset market can lead to the market breakdown during the crisis. Asymmetric information about asset returns generates the "Lemons" problem when buyers do not know whether an asset is sold because of its low quality or because the seller experienced a sudden need for liquidity. The adverse selection can lead to equilibrium with no trade, reflecting the buyers belief that most assets offered for sale are of low quality. However, the ability to trade based on private information maybe welfare improving if adverse selection does not cause the market breakdown.

Provided by: Bank of Canada Topic: Data Centers Date Added: Aug 2010 Format: PDF

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